S&P warns may cut Japan's rating over soaring debt

Standard and Poor's on Tuesday threatened to cut Japan's credit rating unless it produced a credible plan to rein in its soaring debt and lift growth in an economy plagued by persistent deflation.

The warning in the form of a downgrade in Japan's debt outlook coincided with the Bank of Japan's policy meeting, in which the central bank forecast that price declines would be less pronounced than earlier thought.

But the BOJ, faced with renewed calls from the government to do more to support a fragile economic recovery, signaled it was open to relaxing its loose policy even further.

Efforts of governments around the world to spend their way out of the worst recession in decades spawned a series of rating downgrades from Greece to Mexico and fanned market fears those hardest hit might default on their obligations.

While Japan has coped with its massive debt for years thanks to household savings totaling some $16 trillion, the S&P action highlighted the mounting struggle the country faces with a shrinking population and a long stagnant economy.

Even if S&P does downgrade Japan, it will have little impact on Japan's cost of debt, since the overwhelming number of owners of JGBs are Japanese, said Kazuo Mizuno, chief economist at Mitsubishi UFJ Securities in Tokyo.

But this is not sustainable, and there will come a point when the Japanese will start to sell Japan, forcing a hike in bond yields to attract foreign investors.

Japanese policymakers are in a tight spot, with public debt heading toward 200 percent of gross domestic product -- the highest among developed economies -- interest rates near zero and the central bank's several emergency funding schemes still in place.

S&P cut its outlook on Japan's long-term sovereign debt rating of AA to negative from stable, saying that the government's diminishing policy flexibility may lead to a downgrade unless measures can be taken to stem fiscal and deflationary pressures.

The policies of the Democratic Party of Japan, which swept to power in September, pointed to a slower pace of improvement in the government's finances than expected, S&P said. The DPJ has delayed a long-debated increase in the country's consumption tax as part of a plan to reduce deficits.

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Agost Benard, associate director for sovereign ratings at S&P, said in a conference call that the rating could change any time within the two-year horizon of the new outlook.

The outlook cut follows similar warnings from Moody's and Fitch that their ratings hinged on Tokyo's efforts to get government finances under control.

Deputy Finance Minister Yoshihiko Noda sought to reassure markets that the government was aware of the gravity of the challenge, saying it would act to avoid a rating downgrade with a sense of crisis.

The yen dipped briefly and Japanese bond futures slipped after the announcement in after-hours trade. Spreads on Japan's sovereign credit default swaps widened to 90 basis points -- the most in 10 months -- but are much narrower than those of similarly rated Ireland.

Analysts said ratings cuts would have limited market impact given Japan's reliance on the vast pool of domestic household savings for its borrowing. These savings have enabled Tokyo to sell 10-year bonds at yields below 2 percent for the better part of the last decade.

There have been repeated credit downgrades in the past 10 years, and the past record shows they won't have much impact on financial markets, said Naoki Murakami, chief economist at Monex Securities in Tokyo.

S&P said Japan's position as the world's largest net creditor, the yen's status as a reserve currency, a diversified economy and a resilient financial system all supported the country's ratings and mitigated the debt pressures.

Yet the warnings come at the worst possible time for the four-month old government of Prime Minister Yukio Hatoyama, struggling with a funding scandal and facing pressure to deliver on its campaign promises ahead of mid-year upper house polls.

Hatoyama needs a resounding win in the elections to avoid a policy deadlock that the struggling economy can ill afford.

The debt market looks prepared to digest record government supply of new bonds in 2010/11 of just over 44 trillion yen, but longer-term prospects may be less rosy.

With Japan's population aging rapidly, its savings pool may dwindle, driving bond yields higher from current levels near 1.30 percent -- half the level of comparable U.S. Treasuries.

The government estimates a 1-percentage point rise in yields could add 3.8 trillion yen in interest payments in three years. That would be a serious setback given it is looking for savings to finance its social spending agenda, starting with 7 trillion yen in 2010/11 alone.

Feeling the heat, Hatoyama's ministers have been piling pressure on the Bank of Japan to go beyond steps taken so far to support the economy.

The government is worried that deflation, which can encourage consumers to delay spending as they wait for lower prices and companies to cut output, could tip the economy back into a recession.

The central bank expects deflation to last at least three years but said on Tuesday it would be slightly milder in the coming fiscal year than previously thought.

If new policy action is needed, options being floated in the central bank include boosting its purchases of government debt or expanding a low-cost bank funding scheme announced at an emergency meeting last month.

S&P said its final ratings verdict would largely depend on upcoming economic data and how the government proposes to ensure sustained growth and prevent debt from getting out of control in its medium-term fiscal plan due by mid-2010.